Strategic Economics

Moral Hazard and the Incentive-compatibility Constraint

Learn the single inequality that tells you how much money must be at risk before someone changes what they do — and why the answer depends far more on how noisy your measure is than on how much the behaviour is worth.

  • Advanced
  • 13 min total
  • 13 chapters

What decision this helps you make: Whether to pay for a behaviour you cannot observe, how large the variable component has to be to actually buy it, and whether the money is better spent on a better measurement than on a bigger bonus.

What this topic is

Moral hazard is the change in behaviour that happens once someone stops bearing the full consequences of their own actions and you cannot see what they are doing. An insured driver parks a little less carefully. A contractor on a cost-plus deal shops a little less hard. A salaried employee makes the call that is easier rather than the one that is better. The incentive-compatibility constraint is the repair: an inequality stating that the behaviour you want must be the behaviour that is best for the other party, given only what you can actually observe and pay on.

Why it matters

Every commission plan, deductible, retainer, earn-out, equity grant and service-level penalty is an attempt to satisfy that inequality, and most are written without anyone ever computing it. The computation is short, it takes numbers you already have, and it routinely shows that the bonus on the table is far too small to change anything — or that the measure it is paid on is so noisy that no affordable bonus would work.

Who should learn it

Anyone designing a comp plan, negotiating a services contract, underwriting a risk, structuring an earn-out, or explaining to a board why the existing incentive scheme has produced no change in behaviour for three years.

What you will understand

  • The incentive-compatibility constraint written out, and how to solve it for the bonus you must offer
  • Why the true cost of an incentive is a risk premium, not the bonus itself
  • The informativeness principle: a better measure is almost always cheaper than a bigger bonus
  • How to tell moral hazard apart from adverse selection, and why the repairs are opposites

Prerequisites

Common misconception

"Moral hazard means people behave badly once they are covered." It is not a claim about morality and it does not require anyone to cheat. Mark Pauly's correction in 1968 is the one to hold onto: someone facing a price of zero consuming more is behaving exactly as economics predicts anyone facing a price of zero will behave. The second misconception is that a bigger bonus is the answer. The required bonus is the value of the effort divided by how much the effort moves your measure — so on a noisy measure, the number needed can be several times the value of the behaviour, and the fix is a better measure rather than a bigger cheque.